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Fed's Lacker: How to Stop Bailouts for Good

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Jeff Lacker is ready to trade the rough and tumble of monetary policymaking for the angst of financial services reform.

"I do intend to focus on bank regulatory and financial issues," the president of the Federal Reserve Bank of Richmond says in an interview in his office, high above the James River. "It really is the question of our time."

That Lacker's answers differ from those held by a majority of his Federal Reserve colleagues will surprise few. He's solidified a reputation for independence by opposing the Fed's initial rate cuts back in 2007 and casting the lone "no" vote at each of the FOMC's eight meetings last year.

Barbara A. Rehm

Lacker, 57, isn't afraid to speak his mind. In fact, he views it as his duty. And on banking policy, he's convinced the Dodd-Frank Act of 2010 handed way too much power to federal regulators.

"I worry about people taking away from the crisis the lesson that what's key is to respond with maximal force and to provide regulators with maximal discretion across the widest possible terrain," Lacker says. "Enhancing the scope for intervention and enhancing the tools just spreads the poison that boxes us in, in a crisis."

That neatly sums up the divide among policymakers that has emerged since the 2008 crisis. One camp — the one that's firmly in charge — believes the path to financial stability is paved with rules, oversight and enforcement while the other is desperately searching for ways to rebuild market discipline.

These policymakers, including FDIC Vice Chairman Tom Hoenig and Dallas Fed President Richard Fisher, are trying to shift the debate to focus on shrinking financial giants or limiting access to the federal safety net.

But Lacker, who joined the Richmond Fed in 1989 and became its president in 2004, takes another angle. He wants the government to reverse years, even decades, of rescuing any large financial company that gets into trouble. He wants to tie the government's hands so regulators have no funds to finance these bailouts. Only then, he argues, will market participants believe bailouts are over and begin to discipline financial companies themselves.

"The linchpin seems to be the credibility about what we say about who we will rescue," Lacker explains. "We deliberately fuzzed that up in the '80s and '90s with constructive ambiguity. We wanted to maintain the fiction that we would not intervene, but at the same time we tried to preserve the flexibility, the discretion to intervene.

"Well, markets see through that."

Lacker also laments that too many policymakers view any volatility in financial markets as too much.

"There is this acute incentive to avoid being blamed for turmoil that is perceived as avoidable," Lacker says of government officials. "This is the other danger going forward. One thing I fear is just that the preoccupation with financial stability has become an indiscriminate urge to limit volatility."

The best way to convince markets that the era of bailouts has ended is to let a big financial company fail, he says.

"Credibility is going to require us to take actions that will be painful to some, painful to financial markets," including "guiding a large financial institution through the bankruptcy process, unaided with government taxpayer funds."

Asked if the government could simply stand by when markets freeze up, Lacker questions the question.

"Freeze up is a loaded term. There is a lot of implicit theorizing going on when people use metaphors like pipes and ice when they talk about markets," he says. "People on the sell side in a crisis often throw around the phrase that things are frozen or clogged or jammed or dysfunctional, and it's really just people not getting the prices they want.

"As a government official I think we ought to be really shy about coming to the judgment that some market isn't doing what it ought to do, that we know better than market participants what a piece of financial paper ought to be worth."

Lacker traces the recent financial crisis to August 2007, when the Fed cut the discount rate and encouraged banks to borrow. When few did, the Fed cajoled four giants to borrow more than $2 billion in a weird attempt to make it look like going to the discount window was no big deal.

By spring 2008, the government was orchestrating Bear Stearns' sale to JPMorgan Chase, reinforcing to creditors that Washington would never let a big-name financial firm go down.

"Central to the story is what creditors expect us to do in the event of distress," Lacker says. By not letting Bear Stearns fail, "we diffused and diminished the incentive other firms had to raise capital, hunker down on liquidity and put themselves in a condition where they could have weathered the turmoil that came in the fall."

What came that fall was the nationalization of Fannie Mae and Freddie Mac followed by the shotgun marriage of Merrill Lynch to Bank of America.

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Comments (5)
Excellent interview. Bravo Jeff Lacker. From your lips to God's ears!
Posted by commobanker | Thursday, February 07 2013 at 8:47AM ET
Fascinating...Lacker is fighting a losing battle. He said "Government support is not the answer to financial problems." This stated while the Fed continues to print money at the rate of $85billion a month with no end in sight.
Posted by TxTim | Thursday, February 07 2013 at 9:37AM ET
Lacker understands the bailout impulse of his colleagues: now the issue is how to stop them!
Posted by kvillani | Thursday, February 07 2013 at 10:52AM ET
Refreshing and insightful views. The fall of 2008 witnessed a financial panic fed by a cacaphony of arbitrary regulatory actions that bewildered the markets and quickly sent private investors to the sidelines. And while Hoenig and Fisher are right to see solutions in strengthening market discipline it is odd that their proposals are so government and regulation heavy. Anyone consider the enormous amount of regulation it would take to define with operational precision what are the narrow powers that would be left for banks, and the heavy regulatory hand that would be needed to enforce them? And in any event, Lacker correctly points out that with the precedents that have been set in recent years, bailout efforts would extend to the newly expanded nonbank institutions. The markets will ferret out--and rightly take into account--bailout authorities and inclinations retained by the regulators. History of the last few decades shows that neither size (large or small) nor nature of business (banking or nonbanking) is a guide to how regulators will exercise bailout powers to save a failing firm. Wisely, Lacker suggests we look at what really matters instead of fun but distracting debate over size and business lines and return to value-added quality supervision of how firms are managing their business. In that regard, it would be wise to consider the lessons in Alex Pollock's new piece, about discerning between risks that can be to some degree measured and managed, and uncertainty which by definition cannot.
Posted by WayneAbernathy | Thursday, February 07 2013 at 11:02AM ET
Please keep your voice string, Lacker. Your thoughtful comments are delightful
Posted by VAV | Saturday, February 09 2013 at 11:04AM ET
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